Getting Acquainted with Economics

This chapter introduces some of the most central concepts in economics: scarcity, opportunity cost, efficiency, division of labor and exchange. It deals with the ways in which markets coordinate the resolution of the three most basic economic problems: how to produce efficiently, what goods and services to produce and how to distribute the output.

Scarcity, Choice and Opportunity Cost

Because goods and services are scarce, choices must be made. Scarcity - the available resources are insufficient to satisfy people's wants - is universal. All individuals, households, business firms, communities, nations - rich and poor alike - confront scarcity. The fundamental economic problem is the appropriate use of limited resources to produce the goods and services that we value most. Economics, therefore, can be defined as the study of the choices people make in order to cope with scarcity.

The resources (also called inputs or factors of production) that can be used to produce goods and services are divided into four main categories:

The true cost of anything that is scarce is its opportunity cost, what is given up to get it. In other words, the opportunity cost of an action is the highest valued alternative forgone.

Scarcity and Choice for a Single Firm

The production possibilities frontier (PPF) shows the different combinations of various goods that can be produced given the available resources and existing technology. The PPF marks the boundary between combinations of goods and services that can be produced and combinations that cannot.

Figure 4-1 in the textbook shows a production possibilities diagram that holds constant the production of all goods (note: the ceteris paribus assumption) except for soyabeans and wheat. The PPF line separates attainable combinations of production (all points inside and on the line) from unattainable combinations (all points beyond the line). You are already studying the first model of the economy in which everything remains the same except for the production of two specific goods, (i.e., soyabeans and wheat).

Different resources are not equally effective in producing different goods. Thus, along the PPF, producing more of one good has increasing opportunity costs. The convex (bowed-out) shape of the PPF reflects increasing costs. Most activities in the real world are subject to increasing opportunity costs.

The opportunity cost of an action is the highest valued alternative forgone. On the PPF, the the opportunity cost of producing more of one good (e.g., soyabeans) is the output of the other good that must be forgone (e.g., wheat). The opportunity cost of a bushel of soyabeans is the number of bushels of wheat that must be forgone per bushel of soyabeans; therefore, opportunity cost is a ratio. The opportunity cost of a bushel of wheat is the inverse of the opportunity cost of a bushel of soyabeans.

For example, at point C in Fig. 4-1and Table 4-1 we are producing fewer wheat and more soyabeans than at point D. If we choose point D over point C, the additional 8,000 bushels of wheat cost 10,000 bushels of soyabeans. We can also work out the opportunity cost of chossing point C over point D in Fig. 4-1 and Table 4-1. If we move from point D to point C, the quantity of soyabeans produced increases by 10,000 bushels and the quantity of wheat produced decreases by 8,000 bushels. So, if we choose point C over D, the additional 10,000 bushels of soyabeans cost 8,000 bushels of wheat. Opportunity cost is a ratio. It is the decrease in the quantity produced of one good divided by the increase in the quantity produced of the the other good as we move along the PPF. Because opportunity cost is a ratio, the opportunity cost of producing soyabeans is equal to the inverse of the opportunity cost of producing wheat. Table 1 below shows the calculation of the opportunity cost both in terms of soyabeans and wheat. Check that you can understand the calculations. If you can't, don't despair. There will be plenty of examples and discussions in the CONFERENCE section of the classroom.

TABLE 1 - CALCULATION OF THE OPPORTUNITY COST

Scarcity and Choice for the Entire Society

Economic growth is the expansion in production. Two factors cause economic growth:

The greater the rate of capital accumulation and/or technological process, the more rapidly the PPF expands, that is, the more rapid is economic growth. Economic growth is costly. The opportunity cost is incurred because resourses are devoted to manufacturing capital goods and developing new technologies rather than to producing goods for current consumption. Nations that incur the cost of devoting more of their resources to capital accumulation or technological change (Asian Tigers - Fig. 4-4b) grow more rapidly than nations that choose not to pay the cost and thus devote fewer resources (United States - Fig. 4-4a) to such purposes.

The Concept of Efficiency

Production efficiency means that more of one good cannot be produced without decreasing the production of another good. Production efficiency occurs only when production takes place on the frontier line. Because another good must be given up, there is a tradeoff. If we are at a point inside the PPF, such as point G in Fig. 4-3, production is inefficient because there are unused or misallocated resources.

Resources are unused when they lie idle but could be working. For example, we might leave some of the land used for the cultivation of soyabeans idle or some workers might be unemployed. Resources are misallocated when they are assigned to tasks for which they are not suitable. For example, we might assign land best suited to soyabean cultivation to wheat cultivation, or assign skilled soyabean workers to work in wheat cultivation. We could get more soyabeans and more wheat from the same inputs (i.e., land and/or labor) if we reassigned them to tasks that closely match their skills.

If we produce at a point inside the PPF, such as G, we can use our resources more efficiently to produce more soyabeans and more wheat or more of both soyabeans and wheat. But if we produce at a point on the PPF, we are using our resources efficiently and can produce more of one good only if we produce less of the other.

The Three Coordination Tasks of an Economy

Every society must figure out what is referred in economics as the "how", "what" and "for whom" to produce:

1. How to utilize its resources efficiently - it is the choice among different resource combinations and techniques used in the production of a good or service. A good or service can be produced with different resource combinations and techniques; the problem is which of these to use. Since resources are limited, when a greater quantity is used to produce a particular good or service, less quantity is available for the production of another good or service. The problem facing society is choosing the right resource combination and production technique so that the cost in terms of the resources used for each unit of the good or service it decides to produce will be minimal.

2. What combination of goods and services to produce - Since resources are scarce, no economy can produce as much of every good or service as desired by everyone. More of a good or service means less of others. So, society must choose which goods and services to produce and in what quantities.

3. How much of each good to distribute to each person - The problem of how to divide up what has been produced among the consumers, that is, how many of the consumers' wants can be satisfied. Scarcity ensures that society cannot satisfy the wants of all its members.

Specialization

People, businesses and nations can produce for themselves all the goods and services they consume, or they can concentrate on producing one good or service (or, possibly, a few goods or services) and then trade with others, that is, exchange some of their own goods or services for those of others. Specialization is the concentration on the production of only one good or service, or a few goods or services.

The principle of comparative advantage states that each nation (or individual) should specialize in the production of the good or service in which he is more efficient (or less inefficient). Stated differently, an individual or a nation has a comparative advantage in producing something if he can produce it at a lower opportunity cost than anyone else. This stems from the fact that people's abilities differ and, as a result, different people have different opportunity costs of producing a particular good or service.

It should be noted that it is not possible for anyone to have a comparative advantage in everything. Thus, gains from specialization and trade are always available when opportunity costs are different. Specialization requires a system of exchange to enjoy the fruits of comparative advantage. A voluntary exchange must yield mutual gains, that is, to make both parties better off.

Markets, Prices and the Three Coordination Tasks

Markets bring together buyers and sellers of goods and services. A market is any arrangement that enables buyers and sellers to get information and to do business with each other. Prices of goods and of resources, such as labor, machinery and land, adjust to ensure that scarce resources are used to produce those goods and services that society demands. 

Much of economics is devoted to the study of how markets and prices enable society to solve the problems of how, what and for whom to produce:

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